Individual Tax Planning Tips for Those on the Edge of the Fiscal Cliff

Last week, our article "Forget the Zombie Apocalypse: Taxmageddon Is Far Scarier (and Likelier)" highlighted the forces at work that could dramatically increase taxes and worsen the country's overall economic condition. This second installment focuses on the tax changes that affect individuals, regardless of whether they have investment or business income.

The following are the major changes that will cause nearly everyone to pay more taxes:

Marginal income tax rates will increase

The 'marriage penalty' will return

Personal exemptions and itemized deductions will phase-out

Numerous personal tax credits will diminish or vanish

Earned income may be subject to a Medicare surtax

Marginal Tax Rates Will Increase

Right now, for 2012 tax returns, there are six income tax brackets and the top individual tax rate is 35 percent. Beginning in 2013, the lowest tax bracket—the 10 percent bracket—will vanish and tax rate for the remaining five brackets will increase.

Marginal Tax Brackets

2012
Tax Rate

2013
Tax Rate

10%

Eliminated

15%

15%

25%

28%

28%

31%

33%

36%

35%

39.6%

As a result, even if nothing else changed, most taxpayers will pay at least three percent more. Those in the highest and lowest brackets will see even larger increases. Plus, other changes will collide to push taxable income higher and increase the pain caused by the higher brackets.

Think Ahead

A recurring theme is that taxpayers with higher taxable income will be hit harder. Therefore, income-shifting strategies may be more important in tax planning than they have been in recent years.

Marriage Penalty Will Hit Many Couples

One might think that a married couple would incur the same tax liability as two single taxpayers earning the same amounts. While that might make logical or equitable sense, logic and equity seldom come into play in tax law. A disparity already exists in many Internal Revenue Code provisions. And, come 2013, the marriage penalty which has been partially abated since 2001 will return in full force.

Warning

No matter how bad the marriage penalty is for couples who file a joint return, it is far worse for married couples who elect to file separate returns. Not only are these individuals penalized in the tax bracket amounts, but they are penalized in many of the phase-outs. Plus, they forfeit the right to claim numerous credits and deductions.

Filing separately seldom makes sense, although there are a few instances where it is required by law. Filing separately may be advisable when one spouse knows the other plans to commit tax fraud. It could also make sense when one spouse has significant itemized deductions and very little income—however, in this case, the disparity would have to be very great. If you are contemplating a separate return, you should definitely consult with a tax professional.

In 2012, the standard deduction for a married couple filing jointly is 200 percent of the standard deduction available to a single taxpayer. In 2013, this amount is scheduled to drop back to only 167 percent of the single amount. In addition, married filing jointly 15 percent tax bracket will stop at 167 percent of the single amount, rather than at 200 percent. To put some numbers to the percentages, this means that the 15 percent bracket ends at $59,000, rather than $70,000 (based on the 2012 amounts).

Example

Liz and Bryan, married taxpayers, have a combined taxable income of $90,000. They will pay $2,041 more in tax as married taxpayers than they would if they were single taxpayers living in the same home.

Exemptions, Itemized Deductions Will Decrease as Income Increases

Prior to 2001, higher-income taxpayers were required to reduce the amount of their exemptions and itemized deductions. These phase-outs were gradually repealed until they vanished altogether in 2010. Now—unless Congress acts—the phase-outs will return at their pre-2001 levels.

Tip

The term "high-income" means different amounts for different tax purposes. Had these two provisions been in effect in 2012, the phase-out would have started when adjusted gross income (AGI) exceeded $173,650 ($260,500 for married filing jointly).

The return of the itemized deduction phase-out means that the total amount of itemized deductions (other than medical expenses, investment expenses, casualty losses and wagering losses) will reduced by three percent of the amount over the threshold. However, the amount of allowable itemized deduction can't be reduced below 80 percent.

The amount of each personal and dependency exemption will be reduced by 2 percent for each $2,500 (or portion thereof) that the taxpayer's adjusted gross income exceeds the income threshold. The exemption amounts can be phased out entirely. For a single taxpayer, the value of the personal exemption is fully phased out when the AGI reaches $308,650.

Example

Vincent is a single taxpayer whose AGI is $325,000 and whose total itemized deductions were $45,000. His itemized deductions must be reduced by $4,450.40 (($325,000 - $173,650) * 0.03). In addition, the value of his personal exemption is reduced to zero. Both phase-outs serve to increase his taxable income, which could move him into a higher tax bracket, compounding the impact of the increased marginal tax rates. (Note: This example uses the income threshold that would have applied had the provisions been effective in 2012.)

Numerous Tax Breaks Will Be Eliminated or Reduced

Numerous personal tax credits and deductions are scheduled to be reduced or eliminated beginning in 2013. The following are the most significant:

Dependent Care Credit will be reduced from $3,000 per child to $2,400 per child.

Child Tax Credit will be reduced from $1,000 to $500 and the refundable portion will be limited.

American Opportunity Tax Credit for education will be eliminated.

Student loan interest deduction will be eliminated.

Earned income credit phase-outs will be dramatically lowered.

FSA contribution amount will drop to $2,500 from $5,000.

Although most of these credits were of little value to higher income taxpayers because of their phase-out ranges, they were especially important to moderate income families with young children.

Medicare Earned Income Surtax Will Hit High-Income Taxpayers

Both wage-earners and self-employeds pay Medicare (Hospital Insurance) tax on their earnings. Currently, the Medicare tax is a flat rate of 2.9 percent, with no cap on maximum earnings. (Employees and employers each pay 1.45 percent. Self-employed individuals pay 2.9 percent, but have an offsetting tax deduction.)

Beginning in 2013, the Medicare tax rate will no longer be a flat 2.9 percent, regardless of the amount of earned income. Instead, there will be an additional 0.9 percent surtax is imposed on earnings over

$200,000 for unmarried individuals;

$250,000 combined income for married couples who file jointly

$125,000 for a married individual who files a separate return.

Warning

In a radical departure from other employment taxes, this surtax is based on total earned income on Form 1040. Joint filers are taxed on their combined income, rather than on their individual earned income. This creates another "marriage penalty." High-earning individuals who are married will pay a significantly higher amount in additional tax than high-earning taxpayers who live together.

Strategy: Minimize Taxable Income

Now that you have an idea of what may be ahead for next year, it's time to consider steps you can take to keep your tax bill from skyrocketing. The principle behind all of these tax planning tips is minimization of your taxable, earned income. (Next week, we will focus on investment and business income tax planning.) Minimizing next year's income is the opposite of the conventional wisdom for year-end planning. However, the possibility of significant tax increases next year turns all planning advice upside down.

There are three major tactics that you should consider (and discuss with a tax planning professional.)

Shift Income to 2012; Defer Expenses to 2013

If your income is going to be taxed at higher rates in 2013, then you will want to shift as much income as possible into 2012. There are a number of ways that you can do this, such as billing earlier and pursuing collections more aggressively. You will also want to have as many offsetting deductions and tax credits as possible. For many expenses, this is easiest if you are a cash-basis taxpayer because accrual-basis taxpayers must deduct expenses as soon as the obligations are definite. However, whether your are a cash-basis or an accrual taxpayer, you can wait until after the first of the year to make a charitable contributions or to purchase equipment and supplies.

Funding Your Retirement Delivers Short and Long-term Tax Wins

Rather than shift income, consider deferring it through a retirement plan. (For example, you can contribute up to $50,000 to a Simplified Employee Pension (SEP) plan in 2012.) Using this strategy can lower your taxes in three ways:

You will lower your taxable income--perhaps enough to put you into a lower tax bracket, but in any event it will lower your tax bill.

There's another plus: You can take a wait-and-see approach to creating your plan. SEP plans can be created up until the deadline for filing your return (including extensions)!

Corporations Can Structure Payments to Reduce Tax

Corporations can pay both salary and dividends. Dividends are not subject to employment taxes--including the new surtax on earned income.

Warning

The salary/dividend split must be "reasonable" and you must follow the corporate formalities and document the arrangement.

A corporation can also accumulate its earnings to fund future expansion, rather than distributing them to the shareholders. See the BizFilings Business Owner's Toolkit article, "LLC Electing S Corp Status: The Best of Both Worlds," for insights into how an LLC can leverage these strategies.

Next Up: Business and Investment Taxes and Tactics

Next week, we will conclude this series with an overview of the changes ahead for investment income (including increased tax rates on capital gains and a new Medicare tax) and business incentives (such as bonus depreciation.)

We also invite you to register forthcoming webinar: "Taxmageddon or How to Survive a Fall Off the Fiscal Cliff." This free webinar is scheduled for November 1, 2012.